Contagion risk: Could Turkey drag other markets down?

With Turkey in the midst of a currency crisis - the Lira has fallen some 40% this year – there are fears that the chaos could ripple across other markets around the world.

The currency sell-off in recent weeks has already spread to other emerging market currencies and global stocks, Reuters reports.

But could Turkey’s woes really be a catalyst for global upheaval? According to two analysts, while contagion doesn’t regularly occur in financial markets, that’s of little comfort right now.

“With Turkey teetering on the edge of the abyss, fears are that this erstwhile emerging market star could drag other countries down with it, tipping the world economy into recession and leaving its creditors in Europe dangerously exposed. Yet what seems clear at first glance isn’t so obvious on closer inspection,” Pictet Asset Management’s Alain-Nsiona Defise, head of emerging corporates, and Mary-Therese Barton, head of emerging market debt, told Corporate Risk and Insurance.

The country is in a “dark place” with huge foreign currency debts, widening current account deficit and soaring inflation, while a NATO spat with the US and its diplomatic overtures towards Russia and Iran threaten to make matters worse, the pair said.

But it’s important not to overstate Turkey’s significance, they stressed.

“To begin with, its probable recession shouldn’t impact other economies directly. Despite its close ties with the European Union, a population of 80 million and its decade-long growth spurt, Turkey remains a minor player on the world economic stage. It accounts for just 1% of world GDP and only 2.8% of the euro zone’s exports,” commented Defise and Barton.

A greater danger is the damage that might result from a wave of Turkish debt defaults; the country has borrowed heavily over the past 10 years to finance its growth, mostly in foreign currency.

With public and private debt having “ballooned,” a rising dollar and higher interest rates from the US make those debts costlier to service, according to the analysts.

“That’s a headache for European banks,” they said, pointing to Spanish and Italian institutions as particularly eager lenders.

By far the easiest way for Turkey’s woes to spread to other markets is via a shift in market sentiment, according to the pair.

But while there is always the temptation among investors to lump emerging nations together and dump their currencies and assets wholesale at the first signs of trouble, Turkey is ultimately an “emerging market outlier.”

“Of course, should the world descend into an all-out trade war, then global growth would deteriorate precipitously. But if, as we believe, the tariff disputes lead to improvements in how the world trading system functions, then the strong fundamentals of emerging markets should come to the fore. Turkey’s woes won’t alter that.”

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